There are about 4,000 publicly traded companies in the United States. With so many choices, finding the right stock to purchase can be quite an undertaking. Then, once you’ve found a company you trust, you must determine the optimal time to trade. So, how do you make these decisions? One method is technical analysis.
What is technical analysis?
Technical analysis is a method for evaluating investments based on data trends and patterns viewed in charts. This type of financial analysis can be seen as a ‘shortcut’ to predicting the movements of the markets. That’s because technical analysis doesn’t require extensive review of a company’s financial position. Instead, it involves observing trends in price and trading volume, then comparing that data to historical patterns to predict future performance.
Technical analysis can be applied to many types of markets including commodities, currencies, and even cryptocurrencies. However, this article will focus on how it is used in stock trading.
Principles of Technical Analysis in Trading Stocks
Three principles form the foundation of technical analysis when applied to stock markets. These are:
- Stock markets are efficient. This principle assumes that a stock’s price reflects all publicly known data about the company such as revenue, expenses, and debt at any given moment.
- Investors follow the crowd. According to this principle, investors continue to buy when prices are rising and sell when prices are falling unless new data becomes available.
- Repeating patterns can be found in markets. Technical analysis assumes that visible patterns emerge and repeat over time in markets.
In general, stock prices move according to the law of supply and demand. When there is more demand for a stock, its price tends to rise. Demand could escalate because the company has a strong financial position or because investors are optimistic about the company. When price rises and trading volume spikes, this is an indication of more demand for the stock. Since technical analysis assumes that a stock’s price already reflects the company’s financial position, price movements are explained only by new data and changes in investor feelings.
Over time, investor behavior tends to repeat. You can think of it as people jumping on the ‘bandwagon’ for a particular stock. Technical analysis seeks to identify these patterns as they form and use history to predict the next price movement.
Technical Analysis vs Fundamental Analysis
Fundamental analysis studies a company’s “fundamentals” such as earnings, revenue, and debt. This data is used to determine a fair price for the company’s stock. Then, investors decide whether to buy, sell, or hold the stock by comparing the fair price they calculated to the current market price. In contrast, technical analysis ignores direct reviews of company fundamentals and instead relies on reading the chart to project where the price may be going.
Technical analysis can be used independently or together with fundamental analysis to make trading decisions. For example, you could use fundamental analysis to locate stocks with strong balance sheets then use technical analysis to determine an opportunistic time to purchase them.
How is technical analysis useful in stock investing?
Since technical analysis seeks to predict the future price of a stock, it can be helpful in determining which stocks to purchase. Ideally, you would use technical analysis to find a stock whose price is poised to rise. Then, you would purchase it and reap the benefit. Along the same lines, technical analysis can help you decide which stocks to sell.
In addition to helping choose stocks, technical analysis can help you determine when to place trades. If you’ve found a stock you want to purchase, technical analysis can help you predict an opportunistic time to buy. Moreover, if you want to sell a stock, technical analysis can help you identify a selling point.
Common Terms in Technical Analysis
Some of the most common terms you will encounter in technical analysis include the following.
Price & Volume
These two might seem obvious, but for those who are new to investing, we will cover them briefly. Price is the amount a buyer is willing to pay for a stock at a given time. Volume is the number of trades that take place over a given period of time. Price and volume are the most critical data points in technical analysis.
Candlestick charts are specialized graphs that show the price action of a stock over time. Unlike a standard line chart that lists the closing price of a stock each day, a candlestick chart contains additional information such as the stock’s opening price and trading range for the time period.
Most commonly, one candlestick is used to represent each day or week in a series, but they can reflect just about any period of time. If the stock price declined, the chart is referred to as a bearish candlestick and is often colored red. On the other hand, if the stock’s price rose, it is called a bullish candlestick and often colored green.
The color of the candlestick also indicates which side of the ‘bar’ is the open and which side is the close – with close being at the bottom of a bearish or red candlestick and at the top when it is green. The candlestick format is especially valuable for technical analysis as it allows you to see a more complete picture of each period in addition to the general trend of prices over time.
A review of a stock price’s moving average can help you visualize changes over time without emphasizing short-term fluctuations. Moving averages are utilized to show a ‘smoother’ view of the stock’s price than a regular price chart. This less volatile view can help you understand the trend of prices over time by removing the ‘noise’ of short-term fluctuations. Often in technical analysis, multiple moving averages – e.g., 10-day, 50-day, 100-day – are reviewed to gain a fuller understanding of the stock’s movements.
Support & Resistance
You’ll often hear the terms “support” & “resistance” when reviewing a technical analysis of a stock. ‘Support’ in this context is similar to a temporary price floor. It can be based on many factors such as fundamentals, supply and demand, or psychology. The main thing you need to know about support is that a stock tends not to trade below it without new information. For example, if a stock has been trading near $40 and above for an extended period of time and no new information has become available, investors are unlikely to sell their shares for less than $40. However, if new information, such as an earnings report, becomes available, the support level could change.
A resistance level is basically the opposite of a support level. In other words, it is a temporary price ceiling set by the market. For example, if a stock traded near $50 many times without exceeding the level, it indicates resistance. This means investors are unlikely to pay more than $50 for the stock without new information to justify the higher price.
When trading volume declines and prices remain stable, you can interpret this signal as the market settling on a price. This is especially true if the decline in trading volume coincides with increasingly less price movement. Technical analysts refer to this situation as consolidation. When a stock is experiencing price consolidation, it can be a sign that it is poised for a breakout.
Breakout & Follow-Through
Technical analysts call a breakout when a stock’s price falls below the support level or rises above the resistance level and maintains that price. This means that the stock price has broken expectations or broken out of a defined trading range. A breakout is meaningful if the stock price continues its trajectory and momentum. This is called follow-through and can be defined as a high-momentum breakout that continues its trajectory for some time. Depending on the shape of the chart prior to the breakout, you may decide to buy or sell based on the change.
Common Technical Analysis Patterns
As previously mentioned, technical analysis assumes that patterns in stock price and volume repeat over time. These patterns are rarely perfect replicas of past action. Instead, it can be assumed that the general shape of a chart will predict the future trajectory.
Continuation patterns indicate that a stock’s price will continue in the same general direction. For example, a bullish continuation pattern suggests that a stock’s price will continue rising. Some common types of bullish patterns are falling wedge, bullish rectangle, and bullish pennant. On the other hand, bearish continuation patterns suggest that a stock’s price will continue to decline. Common examples of bearish continuation patterns include rising wedge, bearish rectangle, and bearish pennant.
Reversal patterns occur when prices are expected to change from their current path. For example, if a stock’s price had been trending upward and a reversal pattern emerged, you might expect the price to begin to decline.
Some reversal patterns are bullish – meaning they suggest a stock’s price will rise once the pattern emerges. There are many bullish patterns, but some common examples are double bottom, inverse head and shoulders, and falling wedge. Other reversal patterns are bearish – indicating that the stock’s price will fall once the pattern emerges. Common bearish patterns include double top, head and shoulders, and falling wedge.
Learning to read stock charts and identify technical analysis patterns can be time-consuming but rewarding. If you study technical analysis, you can use it along with other data to make wise trading decisions. However, if you don’t have the time or inclination to learn technical analysis, you can partner with an experienced wealth manager who specializes in stock trading. A financial advisor who understands technical analysis, fundamental analysis, and financial planning can help you with every aspect of investing.
Invest in Stocks with Investing Gameplan™ by DreamWork Financial Group
DreamWork Financial Group provides fiduciary advice that is innovative, inclusive, and transparent. Our unique wealth management program, Investing Gameplan™, is available to investors of any net worth. With Investing Gameplan™ you receive a custom portfolio of ETFs and individual stocks as well as access to a fiduciary advisor who trades based on fundamental and technical analysis principles.
With Investing Gameplan™, your advisor is your portfolio manager. So, you have direct access to the person trading on your behalf. With this unique structure, you can understand the philosophy behind trading decisions, ask questions, and have input into your portfolio.
To learn more or get started, contact us.